State secrets and auditing

In a bombshell of an announcement, Hong Kong listed China High Precision Automation Group (CHPAG) announced the suspension of trading in its shares after KPMG disclaimed an audit opinion on the company's results for the year ended June, 30. 2011.

CHPAG has apparently not provided information that KPMG wants to see.

CHPAG is not a state-owned enterprise. It manufactures automation and horological instruments. CHPAG lawyers determined that giving KPMG the information it requested would violate state secrecy laws. This is a new version of the arguments being put forth for why Deloitte cannot produce its working papers on Longtop to the SEC. It is not clear whether any Chinese regulators were involved in the decision.

It is a fundamental principle of auditing that auditors must have complete access to a company's records. Any restriction on this access results in a limitation on the auditor's scope that leads them to disclaim an opinion - meaning the financial statements are unaudited. The failure to present audited financial statements usually leads to delisting.

Here is the wording of KMPG's disclaimer:

Basis for disclaimer of opinion

When performing our audit procedures and seeking independent corroborative evidence, we identified inconsistencies between the information contained in the Group’s accounting records and information independently obtained. The Company’s management explained and showed documents that the Company’s products are related to aerospace and other fields which are classified as state secrets. The Company’s management explained they were unable to provide us with sufficient supporting documentation for us to carry out appropriate additional procedures due to the provisions of the Law of the People’s Republic of China on Guarding State Secrets.

Given these circumstances, there were no practicable audit procedures that we could perform to satisfy ourselves that the information and documents presented to us for our audit were complete and accurate in all material respects, nor could we quantify the extent of adjustments that might be necessary for the Group’s consolidated financial statements for the year ended 30 June 2011.

Disclaimer of opinion

Because of the significance of the matters described in the basis for disclaimer of opinion paragraphs, we have not been able to obtain sufficient and appropriate audit evidence to provide a basis for an audit opinion. Accordingly, we do not express an opinion on the consolidated financial statements as to whether they give a true and fair view of the state of affairs of the Company and of the Group as at 30 June 2011 and of the Group’s profit and cash flows for the year then ended in accordance with Hong Kong Financial Reporting Standards and as to whether the financial statements have been properly prepared in accordance with the disclosure requirements of the Hong Kong Companies Ordinance.

KPMG has resigned as CHPAG's auditors and the company is seeking a new auditor.

This is a major development with respect to the auditing of Chinese companies. It is a further escalation of the struggle that is attempting to resolve the tension between state sovereignty, state secrets, and the role of auditing in the capital markets. It raises the question of whether Chinese companies are auditable in the current regulatory environment. This should set off alarm bells at the SEC and PCAOB, two American regulators that have been struggling to effectively regulate U.S. listed Chinese companies.

While KPMG deserves commendation for having the courage to stand on principle, this saga does not look likely to end well for anyone. China needs to step up and determine how state secrets laws will be applied in connection with the auditing of Chinese companies. There may well be situations where a public listing of a company is simply inconsistent with China's needs to protect its secrets. Those companies need to delist. Otherwise, there needs to be sufficient clarity in the rules to allow the capital markets to function effectively.